Chapter XI EEE Basics of Financial Mathematics Learning Objectives After completion of this unit the students willbe able to explain the origin and history of interest rate lear various forms of interest rate comprehend practical applications ofinterest rate in reallife situation. have an outlook of various economic theory associated with interest rate Explain the relevance of financial mathematics in business and personal life. Develop understanding on the concepts associated with financial mathematics. Explain the steps involvedin the computation of ncome Tax and GST. Develop understanding on the practical applications of net present value; present value interest factor; future value interest factor and annuity. Calculate electricity, water ard other utility bills,11.1 Introduction Finance and Mathematics are pervasive. Be it business activities, economic activities and philanthropic activities, finance and mathematics goes hand in hand. In other words, they are complementary to each other. Even in our daily life we observe that almost every activity where there is usage of money finance and mathematicsis applicable The topic of Financial Mathematics is an integration of finance and mathematics. This topic would assist immensely in comprehending the practical applications of significant concepts like, interest rate; annuity; net present value; discounting; compounding; electricity bills water supply bills; other utllty bills etc. After reading this unit a student would be able to understand the basis of determination of interest rates on various banking and other financial products, thereby, developing the ability to select appropriate financial products on the basis of interest rate, annuity, discounting and compounding. Further, this unit would impart practical knowledge pertaining to reading of electricity, water and other utility bills, thereby making them conversant about the grey areas, like, overcharging of bills; incorrect reading of the meters; faults in the meters; basis of calculation of electricity, water and other utility charges. Unit Structure: Unit Vil Basics of Sub-topics Financial Mathematics Interest and interest rate | Origin ofthe concept of interest; Forms of interest rate; practical applications of interest rate; economic theories associated with interest rate, Accumulation with Meaning and significance of simple and compound simple and compound | interest; formulae; calculations under simple and interest compound interest rates; compound interest rates application on various financial products ete.Video Link for reference: https://www.khanacademy.org/economics- finance-domain/core-finance/interest- tutorial/compound-interest-tutorial/v/introduction- to-compound-interest Simple and compound interest rates with equivalency Annual Equivalent Rate Youtube link hittps://www.youtube.com/watch?v=1gxpwitFinw Effective rate of interest Concept and practical applications, especially in calculating coupon interests on bonds / debentures, wherein interest is compounded half yearly / quarterly. Youtube link: https://www.youtube.com/watch?v=86_OAxOE6k! Present value, net present value and future value Concept and its applications; concept of compounding and discounting; usage of PVAF, FVAF tables; computation of net present value; application of net present value in capital budgeting decisions etc. Youtube link https://www.youtube.com/watch?v=zGRVVSC4UUQ https://www.youtube.com/watch?v=Dtot7aLEtPc Case studies / Caselets on net present value from various reference books on Financial Management would be discussed.Annuities, calculating value of regular annuity immediate Annuity; Annuity Due; Deferred Annuity; Perpetuity and General Annuity Youtube Ink: https://www.youtube.com/watch?v=RqéDafDere https://www. youtube.com/watch?v=joBu9TnFngQ Simple applications of regular annuities (up to 3 period) Tax, calculation of tax and simple applications of fax calculation in Goods and service tax, Income Tax Fundamentals of taxation; direct and indirect tax; tax incidence and impact; Income Tax- Assessment of Individuals; GST- Integrated Goods and Services (IGSN; State Goods and Services Tax (SGST; Central Goods and Services Tax (CGST) and Union Territory Goods and Services Tax (UTGST), Calculation of GST in hospitality sector; power sector etc. Project: Practical questions from various reference books on Income Tax and Indirect Tax (GST) would be discussed. Bills, tariff rates, fixed charge, surcharge, service charge Types of bills; tariff rates- its basis of determination; concept of fixed charge: service charge and their applications in various sectors of Indian economy. Refer: https://www.dwvnl.org/UploadFiles/tariffPlan/NPCL%. 2OTariff%20Order%20-%20Ver%207 pdf Calculation and interpretation of Crucial components of electricity bill; water supply and other supply bills; overcharging of electricity andelectricity bill, water supply bill and other supply bills water supply bills; units consumed in electricity bills; consumer protection laws for redressal of complaints relating to overcharging in electricty, water supply and other supply bills; concept of Ombudsman. Youtube link: https://www.youtube.com/watch?v=4WG8TBISOxU https://www.youtube.com/watch?v=x5InOgkaBic Refer: https://www.theenergydetective.com/bills Project: Students would be assigned with the task of taking reading of power consumption of various electrical gadgets installed in their residence and compute the electricity bill based on the KWH concept, (Comparing interest rates on various types of savings; calculating income tax: electricity bills, water bill service surcharge using realistic data) Interest rates on various savings, fixed and recurring deposits products; steps involved in computation of income tax of individuals and factors considered; computation of electricity bills based on realistic consumption of electtic units of households in delhi (data may be accessed from BSES Rajdhani Power ltd) 11.2 INTEREST & INTEREST RATES. Before youstart you should know how to: Familiarize with different banking transactions helpful in getting a quick overview of the concepts. However, this topic is an attempt to cover everything from very basics and emphasisis given to cover any missing grounds. Insimple terms, Interestis a fee charged on the money that is borrowed.When you borrow money from albank, you pay interest for the use of banks money. When you deposit money in the Savings Account you are paid interest When you borrow money from someone or use somebody else’s money | You have to pay service charge to him. | This amount is paid back to the lender along with the original amount borrowed. | This is known as INTEREST Origin of the Concept of interest Simply put, Interest rate is the cost of borrowing or the price for lending. However, the meaning of interest rate kept on evolving through time and civilizations.In the ancient middle eastern civilization, the practice of ‘food money" was prevalent. People lent seeds andlivestock to others in exchange for more amount or numbers of the same in return. The argument behind this was that seeds and livestock could reproduce and multiply in numbers. But when coins became a medium for exchange, andsince coins can not multiply on its own, the concept of interest rate onthe coins borrowed was introduced. In the medieval era loans were obtained mostly during period of extremities like a bad harvest. Since under such circumstances charging interest was viewed morally wrong, religious institutions forbade interest. The argument was that loans were used for consumption and not production, But in the moder era, with the advent of industrialization and urbanization, people borrowed money with the intention of production and starting new businesses. Thus, many financial institutions came up to provide loans at attractive interest ratesEarning Interest: When you save money in the bank, they will pay you to let them look after yourmoney. Thisis called Earning Interest. Example- If you save 100in an account with an interest rate of 5%, after a year you will have 7105. Earning Interest is a kind of income for a person on the money invested by him. Paying Interest: If you borrow money, banks will charge you for this, This extra charge is called Paying Interest. Example: If you borrow @ 100 with an Interest Rate of 15%, after a year you will owe them? 116. Paying interest is a kind of expense for a person on the money borrowed by him. What is Interest Rate: An Interest Rate is the amount of interest due per period, as a proportion of the amount lent, deposited or borrowed (called the principal amount). So, an interest rate is the percentage of principal charged by the lender forthe use ofits money. An Interest Rate is the overall amount that has to be paid back over and above the original amount borrowed. Interest Rates can be low or high depending on situation to situation, Impact of Interest Rates: It Interest Rates are Low? If the Interest Rates are lowered, this is positive for the consumers as their mortgage repayments are low. Also, lower interest rates means it is less worthwhile to save money in the banks as the interest earned is low. The higher the Interest rate, the more consumers earn by saving their money in the bank. If Interest Rates are High? If the Interest Rates are high, this is negative for the business because they have increased costs in relation to their loan repayments, On the other hand, higher interest rates mean it is more worthwhile to save money in the banks as the interest eamedishighOffered Interest Rates vary from product to product and from bank to bank with No. of factors contributing to the rate of Interest, Types of Interest Rates: There are essentially three main types of interest rates DOE Cea eC iC Cy Dea i) iii) Nominal Interest Rate - The nominal interest of an investment or loan is simplified the stated rate on which the interest payments are calculated. Essentially, this is the rate on which savings accrue interest over a period of time. For example: Investment of = 10,000 at a nominal interest rate of 5% over 1 year would earn the investor® 500. Effective Rate - The effective interest Rate takes into account compounding over the full term of the investment. Itis often used to compare annual rates with different compounding term (daily, monthly, annually, etc.) Real Interest Rate - It is useful when considering the impact of inflation on the nominalinterest rate. 11.3 ACCUMULATION WITH SIMPLE AND COMPOUND INTEREST Interest is charged using one or two methods. These are- Beis Chee ee ee i ‘SIMPLE INTEREST METHOD- Under this method, the interest is charged only on the amount originally lent (principal amount) to the borrower. Interest is not charged on any accumulated interest under this methodFormula for calculating Interest under Simple Interest Method- Interest = P xixn Where: P=Principal Amount =Interest Rate n=No. ofperiods Example: A loan of * 10,000 has been issued for 6 years. Compute the amount to be repaid by the borrower to the lenderif simple interest is charged @ 5% per year. Solution : P= 10,000,i = 5%, n= 6 By putting the values of P, i ,ninto the simple interest formula- 1 =Pxixn =10,000 X 5%X 6 =%3,000 At the end of 6th year, the amount=Principle + Interest of % 10,000 + % 3,000 =%13,000willbe repaid tothe lender. i) | COMPOUND INTEREST METHOD- Under this method, the Interest is charged on the principal plus any accumulated interest. The amount of Interest for a period is added to the amount of principal to compute the Interest for next period. In other words, the interest is reinvested to eam more interest. The interest may be compounded monthly, quarterly, semiannually or annually. When interest is added to the Principal amount, the resulting figure is known as Compound Amount. Formula for calculating Compound Amount and Compound Interest. Compound Amount Formula: A =P (I +i)" Where: A=Compound AmountP =Principal Amount =Interest Rate n =No. of Periods Compound Interest Formula Compound Interest = Compound Amount (-) Principle Amount Principal Amount Example: The Bank has issued a loan of § 1000 to a sole proprietor for a period of 5 years. The Interest Rate for this loan is 5% and the Interest is compounded annually. Compute - (@) Compound Amount (2) Compound interest Solution: Computation of Compound Amount: A=P (+i) = 1000 x (| +5%)" 1000x (| +0,05)* = 1000 x 1.05)" = 1000 x 1.276 = 1276 Interest 1) Divide % 43500 into two parts so that the simple interest an the fist when deposited for one year at 9% per annum and that on the second when deposited for2 years at 10% per annum in abank are the same Solution: Let the first part be xthen 2nd part (43500-x) X.9.1_ 9x Sl= 700 100 Ad) (43600 -x).10.2 for 2ndpart sl= pr 100 (il)from question 9x. _ (43500-1920 100 100 9x = 87000-20x x=%30000 Therefore, 43500-x=%13500 2) Atwhatrate percen per annum will asum of money tripple in 16 years Solution: LetP=x A=3x Sl=3x-x=%2x Slx100 _ 2xx100 PxT — xxl6 =12.5% 3) ASum of money lent art at simple interest amount to % 2200 in one year and = 2800in 4 years. Find the sum of money andthe rate of interest Solution: A:LetP=x Amount= P+ Fit = 2200 =Pc100 +1) =2200x100 (time =p)... @ Again: Amountin4years A=P+ FEA = 2800 =P(100+ 41) = 2800100. woe il) Dividing (ii) by () PQ00+4r) _ 2800x100 _ 28 _14 000+) ~~ 2200x100 22° TT 1100+ 44r=1400+14r 30r=300=r=10% From equation 1 P(100 +10) = 2200x100 20 260 x 100 P =% 2000Computation of Compound Interest: Once the Compound Amount has been computed, the amount of interest earned over the investment period can be computed by subtracting Principal amount from Compound Amount. In this example, the Principal Amount is € 1000 and the Compound Amount as computed above is % 1276, The amount of Compound Interest for the 5 years period canbe computed as follows: Compound Interest = Compound Amount (-) Principle Amount = 1276-1000 =%276 11.4 SIMPLE AND COMPOUND INTEREST RATES WITH EQUIVALENCY ° Compound Interest is the addition of interest to the principal sum of a loan or deposit or in other words interest on interest. It is the result of reinvesting interest, rather than paying out, so that the interest in the next period is then earned on the principal sum plus the previously accumulated interest. Compound Interest is standard in finance and economics. Compound Interest is contrasted with simple interest, where previously accumulated interest is not added to the principal amount of the current period, so there isno compounding. The simple annual interest rate is the Interest amount per period, multiplied by the number of periods per year. The simple annual interest rate is also known as the Nominal interest Rate. (not to be confused with the interest rate not adjusted for inflation, which goes by thesamename), Concept of Equivalency - The nominal rate cannot be directly compared between loans with different compounding frequencies. Both the nominal interest rate and the compounding frequency are requiredin order to compare interest-bearing financial instruments. To help the consumers compare retail financial products more fairly 12and easily, many countries require financial institutions to disclose the annual compound interest rate on deposits or advances on a comparable basis The Interest Rate on an annual equivalent basis may be referred to variously in different markets as Annual Percentage Rate (APR), Annual Equivalent Rate (AER), effective interest rate, effective annual rate, annual percentage yield and other terms. The effective annual rate is the total accumulated interest that would be payable up to the endof one year, dividedby the principalsum. * There are usually two aspectsto the rules defining these rates:- 1) Therateisthe annualized compoundinterest rateand 2) There may be charges other than interest, The effect of fees or foxes which the customer is charged and which are directly related to the product, may be included, Exactly which fees and taxes are included or excluded varies by country may or may not be comparable between jurisdictions because the use of such terms may be inconsistent, vary according to local practices, Compound Interest 1 Ans. Find the amount of Rs 20,000 atter 10 years at 8% converted quarterly for the first 4 year and at 6% compounded monthly thereafter. Case-1 Forthe first 4 years nl =4x4= léyears 8 ate =i, = =0.02 " «100 Case-2forthenext 6 years n, =6x12=72 0,005 T2100Amount on compound interest Clafter 10 years 2) Ans. =PA+i)" (+i) = 20000(1+ 0,02)'* (1+0,005)’" = 20000 x(1+0.02)'* x(1.005)’? = 20000 x1.3727 «1.4320 = 39314128 = 39314.13 The difference between the Cl and Sion acentrain sum of money at 40% per annum for 2 years is Rs 500. Find the sum Let principal P=9 Px10x2_P sl = ap Too 5 {7,10 (121-100) _ 21 cr = Pit 2} 1] app 21100) _ 21 (8) >)-° Fe) 21, P aoe 800 => 2P-20P = 500x100 => P=%50000 Example: (@) _ 21000is deposited into savings account paying 20% per annum Compounded annually. At the end of 1 year Compound interest 1000 X 20% =% 200 Interest rate is credited to the account Amount = 1000+200 = % 1200. The account then earns Compound interest of 1200 X 20% =% 240 in the second year. (b) Arate of 1% per month is equivalent to a simple annual interest rate (nominal rate) of 12%but allowing for the effect of compounding the annual equivalent compound rate is 12.68% perannum {(1.01)-1) (©) The Interest on Corporate Bonds and Government Bonds is usually payable twice yearly, The amount of interest paid (each 4six months) is the disclosed interest rate divided by two and multiplied by the principal. The yearly compounded rate is higher than the disclosed rate. ¢ It is sometimes mathematically simpler to use continous compounding which is the limit as the compounding period approacheszero, ¢ Continuous compounding can be thought of as making the compounding period infinitely small, which is achieved by taking the limit asn goes to infinity. Practical Application of interest rate: Let us try to understand application of interest rates from a bank’s perspective. A bank is a financial institution which engages in borrowing and lending with public and private entities. Bank charges interest on lending and provides interest upon borrowing, The fine balance between the two interest rates drives the character of the economy. Borrowers come to bank for loans for businesses, education, personal and various other purposes. The bank agrees to do so but at a certain fixed rate. The bank may not always have alll the money by itself to lend. So, it offers an attractive interest to entities agreeing to deposit their money with the bank. So, from a bank's perspective higher positive interest rate is the result of lack of sufficient loanable amount. This encourages entities to deposit and save more. A situation when a bank is getting overwhelmed with deposits of fund, the interest comes down encouraging entities to take loans and spend more. In certain rare situations, like aeconomic recession, the rate may approach the limiting value of zero discouraging savings and encouraging more and more spending. It is interesting to note that in recent times many countries like Sweden, Switzerland, and Japan have implemented negative interest rate making savings an unattractive option. This tends to be the case when people hoard more and more money without spending it, Cleatly, interest rate Is a very Important tool for the government, financial and regulatory institutions to control and regulate the character of the economy.Economic Theory associated with interest rate: The great Greek philosopher Aristotle's view had a great influence on the society He condemned the charging of interest on lending money as “unnatural’. He believed that the nature of money is to facilitate exchange and was strongly against making gain from money itself. David Hume’s classic essay “of money" had an important proposition on interest and its variations. He argued that interest depends on demand for borrowing, riches to supply demand and profits arising from commerce. The classical theory of interest, which had contributions from a number of economists, argued that interest rate ensures equilibrium between demand for borrowing andlending. Henceforth, many more sophisticated theories of economics were proposed which made great contributions to the development and understanding of the concept of interest. However, discussion of those would be beyond the scope of this chapter. 11.5 EFFECTIVE RATE OF INTEREST The effective rate of interest is the real return on a savings account or any interest paying investment when the effects of compounding over time are token into consideration. It reveals the real percentage rate owed in the interest on a loan, a credit cardorany debt. Itis also known as- the Effective Rate or the Annual Equivalent Rate. a Concept of Effective Interest Rate - A bank certificate of deposit, a savings account of a loan offer may be advertised with its nominal interest rate as well as its effective annual interest rate. The nominal interest rate does not reflect the effects of compounding interest that comes up with these financial products. The effective annual interest rate is the real return.KEY POINT: The more frequent the compounding periods, the greater the return, Formula for Interest Rate which is Effective: Effective Annual Interest Rate = (1+i/n)"-1 Where: i= Nominalinterest Rate n=Number of Periods Example of Effective Annual Interest Rate: Considertwo offers: © Investment A pays 10% interest, compounded monthly. e Investment B pays 10.1% compounded semi-annually. Which is better offer? Solution: In both the cases the advertised interest rate is the nominal interest rate, The effective annual interest rate is calculated by adjusting the nominal interest rate for the number of compounding periods the financial product will experience in a period of time. In this case, that petiodis one year. Following are the calculations:- Effective Annual Interest Rate for A &B Investment A= (1 + 10% / 12)" - 0.47% Investment B= (1+ 10.1% /2)? - 1 10.36% CONCLUSION: Investment B has a higher stated nominal interest rate, but the effective annual interest rate is lower than the effective rate for Investment A. This is because Investment B compounds fewer times overthe course of the year. Concept of More Frequent Compounding Equals Higher Returns - As the number of compounding periods increases, so does the effective annual interest rate, Quarterly compounding produces higher returns 7than semi-annual compounding, monthly compounding more than quarterly, and daily compounding more than monthly, Below is the breakdown of the results of these different compound periods with a 10% nominalinterest rate- Semi-annually = — 10.250% Quarterly = 10.381% Monthly = 10.471% Dally = 10516% The Limits of Compounding- There is a ceiling to the compounding phenomenon. Even if compounding occurs an infinite amount of times - not just every second or microsecond but continuously - the limit of compoundingisreached Short trick for calculating Effective Interest Rate(to be solved on Calculator) Base= 1 year m R/100+1X100= -100= Effective Rate (Yearly) L__, I time m R/200+1X 100=-100= Effective Rate (Half Yearly) U__+ 2times m R/400+1X 100=-100= Effective Rate (Quarterly) L__+ 4times M R/1200+1X 100=-100= Effective Rate (Monthly) L, 12times 11.6 PRESENT VALUE, NET PRESENT VALUE AND FUTURE VALUE > Present Value: The concept of present value is one of the most fundamental and pervasive in the world of finance. It is the basis for stock pricing, bond pricing, banking, insurance, ete.Insimpler terms, present value accounts for time value of money. Present Value describes how much a future sum of money is worth today. It accounts for the fact that money we receive today can be invested today to earn areturn. Formula for Present Value CF aq+n” Where: CF =Cash Flowin Future Period r= Periodic Rate of return or Interest (also called the discount rate or the required rate of return) n=no. ofperiods Present Value explained through an Example: Assume that you would like to put money in an account today to make sure you have enough money in 10 years to buy acar, Ifyou would like to have 710,000in 10 years and you know you can get 5% interest per year from a savings account during that time, howmuch should you putin the account now? Applying the Present Value formula- CF = 210,000 = 5% = 10 oF ar 10,000 (1+0.05)" 6139.13Interpretation: Thus, = 6139.13 will give you 710,000 in 10 years if you can earn 5% each year. In other words, the present value of €10,000is %6,139.13 Net Present Value (NPV) : Net Present value is the difference between the present value of cash inflows and the present value of cash outflow over a period of time. Net Present Value is used to analyse the profitability of aproject. Formula for calculating NPV S CFn NPV=)) Initial Cash Investment mm +i Where: n= Cash Flow Period i= Interest Rate Assumption What is Positive NPV 22? Apositive NPV indicates that the projected earings generated by a project orinvestment exceeds the anticipated costs. Itis assumed that an investment with a positive NPV will be profitable and an investment with a negative NPV will result in Net loss. This concept is the basis for the Net Present Value Rule, which dictates that only investments with positive NPV values should be considered. NPV’s canbe calculated by using tables, spreadsheets etc. Mlustration: Let us say X Ltd. wants to expand its business and so it is willing to invest 210,00,000 The investment will bring an inflow of 1,00,000 in first year, %2,0,000 in the second year, %3,50,000 in the third year, ¥2,65,000 in the fourth year and %4,15,000in the fifth year. Assume the discount rate tobe 9%. 20Letus calculate NPV using the formula Year Flow Present Value Computation oO 10,00,000 10,00,000 — 1 1,00,000 +91743 100000 / (1.09) 2 2,50,000 42,1019 250000 / (1.09) 3 3,50,000 + 270264 360000 / (1.09)° 4 2,65,000 +187732 265000 / (1.09)* 5 4,15,000 +269721 415000 / (1.09)* +2988) Hence NPVis%29,881 Interpretation: Since the NPV is positive, the investment is profitable and hence X Ltd. Can go ahead with the expansion. a Future Value Future Value is the value of an asset at a specific date. It measures the nominal future sum of money that a given sum of money is ‘worth’ at a specified time in the future assuming a certain interest rate, that is, the rate of retum, Itis the present value multiplied by the accumulation function. The value does not include corrections for inflation or other factors that affect the true value of money in future, Understanding Future Value : The future value calculation allows the investors to predict, with varying degree of accuracy, the amount of profit that can be generated by different investments. Investors are able to reasonably assume an investment’ s profit using the future value calculation. Determining the future value (FV) of a market investment can be challenging because of market's volatility. Types of Future Value: @ Future value using simple Annual interest- 21It assumes a constant rate of growth and a single upfront payment left untouched for the duration of investment. Iraninvestment earns simple interest, then the future value (FV) Formulais- FV=Ix(1#(@XD) Where: 1=Investment Amount ReinterestRate T=No. of years Example: Assume 21000 investment is held for years in savings account with 10% simple interest paid annually. In this case the FV is 71000 (1 +(0.10X 5) =@1600 @ Future value using Compounded Annual interest- With compounded interest, the rate is applied to each period’s cumulative account balance. The formula for calculating the Future value of investment earning Compoundinterestis FV=IX(1+R)' Where 1=Investment Amount R=InterestRate T=No. of Years Example: Using the above example, the same 71000 for 5 years with 10% compounding interest rate would have future value of %1000 x ((1+0.10)°) =7161051 11.7 ANNUITIES, CALCULATING VALUE OF REGULAR ANNUITY An annuity is aseries of payments made at equal intervals. Examples of annuities are regular deposits to a savings account, monthly 22home mortgage payments, monthly insurance payments, pension paymentsetc. Annuities can be classified by the frequency of payment dates. The payments may be made weekly, monthly, quarterly, yearly or any other regular interval of time, An annuity which provides for payments for the remainder of a person’s lifetime is allife annuity. Types of Annuity: i) Ordinary Annuity : An ordinary annuity makes payments at the end of each period. For example - Bonds generally pay interest at the end of every six month, Example : Repayment of housing load of equal instalments. i) Annuity Due: With an annuity due, by contrast, payments come at the beginning of each period. For example - Rent, which the landlords typically require at the beginning of each month is a common example a) LIC Payment ¢) Recurring deposit Payment, ii) Deferred Annuity : An annuity which is payable after the tapse of a number of periods is called deferred annuity. Example : Pension Plan of LIC, ordinary annuity is also known as Annuity immediate. Ifa person pian to invest a certain amount each month or year, it will tell how much willit have accumulated as of future date, For Example: A series of five 1000 payments made at regularintervals- End of Each Period 0 1 2 3 4 5 Po 21000 z1000 z1000 21000 z1000 be Payment paid or received at end of each period 23Let us assume that you invest 21000 every year for next 5 years at 5% Interest. Thisishow much youhave at the end of five year period - 0 1 2 3 4 5 21000 21000 21000 21000 1000 1000(11 .05)°=%1000 1000(1.05)'=%1050 Future Value of Ordinary Annuity $5525.64 Characteristics of Annuity @) Same amountsis paid at equal time interval b) __ Instalments are due at the end of each period or at the beginning of each period Formula for Future Value FV = cxj 201 3 | Ordinary Annuity Where: C=CashFlowperperiod i=Interest rate n=Number of Payments In above example- 6 Annuity = =1000 fae) = — %1000x5.53 = 75,525.63 or 5525.64 (roundoff) Formula for Present Value Pv = Ordinary Annuity In above example- 24pv . (-(+0.05)* Ordinary Annuity = — %1000x{ "==>" rary Arty [ozs = 31000x4.33 = 4329.49 Example 1: Aman deposits ina bank Rs 16000 at the end of each year, for 8 years, if the rate of interest is 10% per annum compounded annually. What would be the sum standing to his credit at the end of that period. Ans: t 10 C =16000,i Too "700 1 n=8 years Amount = ¢((1+0"-1) = 16000114 0.0*-1) 160000 (100° -1) Let x=(.0° log x=8log1.1 (taking log both sides) =8x0,0414 = 0,3312 x=antilog 0.3312 =2.144 A =16000(2, 144-1) = 160001.144 =Rs, 18304 Example 2 : Find the least number of years for which an ordinary annuity of Rs 1500 pet annum must run in order that its amount just exceeds Rs 30000 at 9% compound annually Ans.: A=Rs 30000, a=Rs. 1500 2 100 we have A=S@s0"-1) 1800 0.09 30000x0.09 1500x100 i = 0,09 3000 = = ((1+0.09)" -1) =(1+0.09)" -1 25141.8 =(1+0,09)"" 2.8=(1.09" Log 2.8 =nLog!.09 0.4472 =nx 0.0374 0.4472 n= 0.0374 =11.957 =12 years Example 3 : A fim anticipates a Capital expenditure of Rs 100000 for a new equipment in 5 years, how much should be deposited quarterly in a sinking fund carrying 12% per annum compounded quarterly to provide for purchase. Solution : Let Rsx per quarter be deposited Instalment=Rs. x, ime =5 years = 20 quarters Rate = 12% p.a, = 30% per quarter Amount =Rs 100000 Weknow A= a+" -1) i Let p=(1.03)" Logp = 20Log1.03 = 200.0128 = 0.256 p = antllog 0.256 = 1.803 _100000x0,03 _100000x0.03 _ 3000000 7.803 803 803 Log x=Log sore = Log 3000000 - Log 803 =6,4771- 2.9047 3.5724 = Antilog 3.5724 =Rs, 3736 Example 4 : Nidhi buys a LCD set worth Rs 48000 on instalment plan under which Rs 8000 is to be paid immediately and the balance in 15 equal instalment (annualy) with 18% perannum compoundinterest. How much has he to pay annually 26Ans. : Cost of TV Set = Rs 48000 Down payment = Rs 8000 Balance = Rs 40000 Let each instalment =x 1-04)" i x 5 40000 = *_[1-+0.18""® a al (1+0.18) x is piel +18] 0) Let p =(1.18)"* = Logp =-15Log 1.18 =.15x0.0719 =-1.0785 =p =antiLog (2.9219) = 0.0834 x D = 40000 = al! - 0.08347] _ 40000x0.18 _ 72000 ~~ 0.91653” 9.1653 Log x =Log 72000-Log 9.1653 = 4.8573 - 0.9621 = 3.8952 > 200K = anti Log 3.8952 = 7856 hence each instalment = Rs, 7856 Example 5 : Same for a child’s education, a family decides to invest Rs. 3000 at the end of each 6 month period in a fund paying 8% per year compounded semi annually. Find the amount of the investment at the end of 18 years. Solution P=Rs3000 n=18x2=36 _ 8 * 3909704 Let Abe the amount of annuity then A=P| on) 1+0.04)* — (doa — = 2000 3000) 0.04 27Letx=(1.04)* Logx=36 Log 1.04=36x0.0170=0.612 x= AntiLog0.612= 4.093 x = Anti Log 0.612 = 4.093 (4.09. 3-1) A= 3000 —" ~ 3000 (77.325) = 231975 100. 0.04 000 ¢ ) Amount =Rs 231975 4 — Calculation of Future Value of Annuity Due Beginning of Each Period o 1 3 4 5 i 1 i l L 1 1000 1000 1000 1000 1000 Payment paid orreceived at beginning of each period Following the previous example- 0 1 2 3 4 5 21000 21000 21000 21000 21000 31000(1.05)' 31000(1.05)* = 71000(1.05)‘= %1215.51 = %1000(1.05)°= %1276.28 Future Value of Annuity Due 5801.92 28Formula for Future Value FV = coos Annuity Due In above example- FV it 14+-0.05)° -1 AnnuityDue= —_@ 1000x| @40-99 = hq, nuity Du 1000 [ 3.08 |e 0.05) %1000x5.53x 1.05 %5801.92 Formula for Present Value Pv = ox Ean i Annuity Due ~ In above example- PV AnnuityDue= = 1000 +f 5 =0+0.08)*} 4, 9.05) 00 | = 21000x 4.33 x 1.05 = 4545.95 11.8 SIMPLE APPLICATIONS OF REGULAR ANNUTIES (Upto 3 periods) Anannuity is a series of equal cash flows, equally distributed over time, Examples of Annuities abound - © — Mortgage Payments 29Car Loan Payments Leases Rent Payment Insurance Payouts, andso on Ifyou are receiving or paying same amount of money every month (or week oryear, or whatever time frame), then there is an annuity. A regular annuity is simply an annuity where the first payment is made at the endof the period, The picture below shows an example of a 3-period, “100 regular annuity. 0 a 100 100 100 Notice that we can view the annuity as a series of three Rs, 100 Jumpsums or we can treat the cash flows as a package. Calculating the Future Value of a Regular Annuity Asnoted, annuity can be treated as a series of lump sum cash flows. N FV, = }CRd+D a Using the example shown in the time line (above) and a 9% period interest rate, we get- FV, = 100(1 +0.09)* + 100(1+0.09) + 100 = %327.81 Analysis: Note that future value of regular annuity is in the same period as the last cash flow. So the first cash flow must be taken two periods forward, the second cash flow must be moved one period ahead and the last cash flowis already there, soit doesnot move at all 30Therefore, if the Interest Rate is 9%, then the future value of this annuity is %327.81 atthe endofperiod3. The formula shown above works fine, but its tedious if the annuity has more than a few payments. Fortunately, we can derive a closed form version of that equation which means that we don’t have to iterate through a series of sums. The closed form equation is- vm Where Pmt is the per period annuity payment amount(-100 in our example) This formula is much easier to use, no matter how many payments there are. In this case, it gives us- +0.09)° 0.09 FV, = 100} |-227 81 whichis exactly the same as we got previously. Example: Imagine that you are planning to retire in 35 years and you think you can afford to save %600/- per month, Further, you believe that you can reasonably eam about 8% peryear without taking too much tisk How much amount will youhave accumulated at the time you retire? In this example, Pmt is 2500/- because you plan to save that amount each and every month. The number of periods N is 420 months and the interest rates 0.667% per month: In this case, we are making monthly investments so both N and i must be converted to monthly values. Solving the closed form equation, we find that you will have — [+0.00667) -1] PV, =800| =71,146,941,24/- 31Interpretation: We just found that investing ¥500 per month @ 8% per year will result in the nest egg of 71146941 after 35 years, 11.9 TAX, CALCULATION OF TAX AND SIMPLE APPLICATION OF TAX CALCULATION IN GOODS AND SERVICE TAX, INCOME TAX a Whats Tax? Taxis money that people have to pay to the government. A tax is a compulsory financial charge or some other type of levy which is imposed by a governmental organization in order to fund various public expenditures For example, taxes ate used to pay for the people who work for the government, such asthe military and the police, provide services such as the education and health care, and to maintain or build the things like roads, bridges etc. So, taxes are the primary sources of income for the government through which it fulfills various projects and initiatives. Taxis vital for the country’s economic progress, sustenance and development. Taxes prevalent in India In India there are two types of Taxes prevailing i.e. Direct Tax and Indirect Tax. Generally, taxes which are directly collected from tax payer are called Direct Taxes and taxes which are indirectly collected are called Indirect Taxes. As you can see in below eR SE [eric] hierarchy, Direct Tax are further divided into Income [FE [corporate tax ] Tax, Capital Gain Tax, Corporate Tax. Similarly, Indirect Taxes are further [ian —| divided into two Le. GST custom ouTY (Goods and Services Tax) and Custom Duty. 32az Computation of Income Tax Income from Salary XXX Income from House Property XXX Income from Business or Profession XXX Income from Capital Gains XXX Income from Other Sources XXX Gross Total Income XXX Less: Deductions (Limit *150000) XXX (PF PPF, LIC, housing Loan, FD, NSC) Taxable Income XXX (Rebate of 712,500 is available if taxable income is upto 75,00,000) Applicable Tax Rate For the financial year 2020-21 (Assesment year 2021-2022) rate of income tax is asunder Slab Income Tax Rate Health and Education Cess Upto2.5Lakh | Nil 4% 2.5-5.0Lakh | 5%ofamountby which taxable income exceeds Rs 2,50,000 5.0-7.5 Lakh Rs 12500 + 10% (taxable income 2,50,000) a% 7.5-10Lakh Rs 37500 + 15% (taxable income 7,50,000) A% 10-12.5 Lakh Rs 75000 + 20% (taxable income 10,00,000) A% 12.5-15 Lakh Rs 1,25000+25% (taxable income 12,50,000) 4% Above 15Lakh]| Rs 187500 + 30% (taxable income 15,00,000) 4% Example 1: Income from Salaries is = 4,00,000 for the financial year 2019-20. Calculate Income Tax liability ifthe deductions under LIC is 50,000, Solution- Income from Salaries Gross Total Income Less: Deductions Taxable Income 33 %4,00,000 %4,00,000 50,000 %3,50,000Tax Calculation upto € 2.50 lacs NIL (%350000 - %250000) X 5% 25,000 TOTALTAX %5,000 * Since Taxable Income (350000) is less than 7500000, so Rebate of 712500 is available. Hence totaltax payable is NIL. EXAMPLE2: Income from salaries is %2,00,000. Income earned from House property rentals %1,00,000. Income under head Business and Profession, come out to be 22,50,000. Income under head capital gain is® 1,00,000. PF contribution is $50,000, LIC is 50,000. Calculate Income Tax Liability SOLUTION Income from Salary 2,00,000 Income from house property 1,00,000 Income trom Business profession __2,50,000 Income from Capital gains 1,00,000 Gross totalincome 6,50,000 LESS : Deductions PF contributions (60,000) LIC (60,000) Taxable Income “5,50,000 Calculation of Tax —— 0 - 250000 NIL (6,00,000 - 2,50,000)x5% 12,500 (6,50,000 - ,00,000)x20% 10,000 TotalTox 22,500 e Since taxable Income is more than “5,00,000, no Rebate is available. 34EXAMPLE 3: Raman’s monthly salary is Rs 1.93 800, HRA is 24% of Basic Salary and Transportation allowance is Rs 8424 per month. he deposits Rs 40,000 om GPF and pays Rs 45000 per month as the income tax for 11 month, How much income tax Raman stillhave to pay. SOLUTION Salary : Rs, 1,93,800 HRA =1.98,800%24 54 46, 519 100 TA =Rs 8240 Net monthly Salary = 1,93,800 + 46512 + 8424 =2,48,736 Annual Salary = 12x248736 = 2,984,832 Income tox= 187500 1x (2,984,830 -100000) = 6,32,949 Health and education cess = = 25317.96 = 25318 6329494 10 Surcharge = 25% of Income Tox = 25 6,32,948 = 168237.25 100 = 158238 Net Income Tax = 6,32,949 + 25,318 + 1,58,237 = Rs, 816504 Tax already paid in 11 month =45000x 11=Rs 4,95,000 Tax Payable = - Rs 8,16,504 Rs 4,95,000 Rs. 3,21,504 36Check Your Progress: Q Mr X had income from salary of 200000. Income from Capital Gain of %150000 and income from other sources is 250000. Contribution to PF is 40000, PPF ~70000, and LIC is 40000. Calculate Income Tax Liability of Mrx. Mr A had Income from Salary of 7300000. Income from House properly rentals comes out to be 7150000. Income from Capital gains is 300000. Income from other sources is ®50000. Deduction made under section 80 C PF - 40,000 PPF - 40,000 Fixeddeposits - %30,000 Lic = %40,000 Calculate Income Tax liability of Mr. A About GST (Goods & Service Tax) Goods and Services Tax which is abbreviated as GST is the form of Tax which has been Imposed by the Government of India at National Level. The GST levied by the Government of India on the sellers, manufacturers and consumers of goods and services at a National Level GST is derived from the concept of Value Added Tax which means that it is applied at each stage and the consumer is supposed to pay the GST amount which is charged by last dealer or the supplier in the supply chain. Different Tax Heads under GST GST can be categorized in four different heads such as 1 2. State Goods and Services Tax (SGST) - State Government collects this Tax. Central Goods and Services Tax (CGST) - Central Government collects this Tax. 363. Union Territory Goods and Services Tax (UTGST) - Union Territory Government collects this tax. 4, Integrated Goods and Services Tax (IGST) - It is collected by the Central Government for Inter State transaction. IGST is also levied on import of goods and services into India and an export of goods act side India. Remember CGST + SGST : Revenue is shared equally between centre and state. IGST - Revenue is collected by Central Govt and is shared with the State as the basic of destination of goods, a GST calculation formula For calculating GST, following mentioned formula can be used by the tax payer. Following formula helps to calculate net price of the product after application of GST and removing GsT as well, The formula for GST calculation - 1. AddGsT GST Amount = original cost x GST %)/100 Netprice — =original cost +GsTamount 2. Remove GST GST Amount = original cost - (original cost x {100/(100+GST%)}) Net Price = original cost - GST Amount Example - Lets assume that a product is sold for Rs. 2000 and GST applicable to that products 12%. Then the net price of the product becomes Rs. 2,000 + 12% of $2,000. This comes out as%2,000+%240 =%2,240 11.10 BILLS, TARIFF RATES, FIXED CHARGE, SURCHARGE, SERVICE CHARGE a BILLS 37A bill is a written statement of money that you owe for goods and services. If you bill someone for goods or services you have provided them with, you give or send them a billlstating how much money they owe you for these goods andservices Bill also called as, Invoice or Tab is a commercial document issued by aseller to a buyer, relating to a sale transaction and indicating the products, quantities and agreed prices for the products or the services the seller had provided the buyer. Example INVOICE/BILL ‘Company Name 123, Wall Street Invoice No. Date Terms Description ‘Amount Owed Invoice Total [Currency] TariffRates A tariff is a tax imposed by a government on good and services imported from other countries that serves to increase the price and make imports less desirable or atleast less competitive, versus domestic goods andservices, Tariffs are generally introduced as a means of restricting trade from particular countries or reducing the importation of specific types of goods and services, For Example: In order to discourage the purchase of Italian leather handbags, the U.S government could introduce a tatiff of 50% that 38dives the purchase price of those bags so high that the domestic alternatives are much more afferable. The government's hope is that the added cost will make the imported goods much less desirable, A atte is derived from the data in the tariff of rates, for example, schedules and rating tables. This rate is set forth by a rating organization. Fixed Charge: A fixed charge is any type of expense that recurs on a regular basis, regardless of the volume of business. Fixed charge mainly include loan (principal and interest) and lease payments. Interpretation If your business borrows money from the bank, the bank may say it wants to take a fixed charge over a particular asset of your business, for example, your business premises. This means if your business stops repaying the bank, it can seize your business premises and sell them to recover the money it owed. Important Holders of fixed charges takes precedence over most other creditors if businessis liquidated, For example, if your businessis in liquidation, a bank holding a fixed charge over your business's property would be entitled to be repaid fist from the sale of property. Only money left over from that sale could go to the rest of the creditors, If you have given fixed charge on one of your business's assets, you can’t usually sell that asset without permission from creditor who holds fixed charge. Surcharge Asurchargeis an extra fee, charge or tax that is added on to the cost of a good or service, beyond its initial price. Surcharge is ‘Tax on Tax’, This charge reflects alocality’sneedito collect the money for extraservices, a 39hike to defray the cost of increased commodity pricing, such as with a fuel surcharge or extra fee on your wireless bill for access to emergency services. Many Industries, including travel, telecom and cable will add surcharges to offset the cost of higher prices, such as fuel, or regulatory fees Imposed bythe government. Surcharge in relation to Taxes Surcharge is an additional charge or tax levied on existing tax. It is levied as percentage on the income tax payable as per normal rates. In case, no taxis due for the financial year, then no surcharge islevied, The revenue eatned via surcharge is solely retained by the Centre and is not shared with the States. Collections from surcharge flow Into the Consolidated Fund of India. Service Charge % Aservice chargeisa fee collected to pay forthe services related to the primary product or service being purchased. The charge is usually added at the time of the transaction. * Many Industries collect service charges including restaurants, banking and travel and tourism. When collected, these charges may cover service rendered to the customer or they may cover administrative or processing costs. * Service chargesare paid directly to the company. For example - A concert venue may charge a service fee in addition to the initial price of a ticket at the time of purchase in orderto cover the cost of secutity or for providing the convenience of electronic purchases Service Charges are also called as Service Fees. They go by no. of different names depending on the industry, including booking fees (hotels), security fee (rave), maintenance fee (banking) and customerservice fee. 40GST Question: Aman buys a LCD at Rs 40,000 at a discount of 20% on printed price find and sills it at printed price. If the sales are intra-state and the rate of GST in 12% a) price atwhichLCDis bought by retailer ) price at which the consumer bought LCD ©) GST paidby retailer ) GSTpaidby consumer Rate of GST = 120% that will be shared by centre and states equally at6% cost of LCD =Rs. 40,000 Discount = “200022 _ ps 8,000 Net price of LCD = Rs 40,000- Rs 8,000=Rs 32,000 SESTpaid by retalor= 555%, $2,000 =. 920 CGSTpaidby retailerto wholesaler= Total GST paid by retailerto wholesaler Rs 1,920+ Rs, 1920= Rs 3.840 @) Purchase cost of LCD = Rs. 32,000 + Rs 3,840 = 35,840 b) Retailer sells the LCD at the fixed price ConsumerbuysLCD at printed price Rs 40,000 SGST paid by the consumertothe retailer = scorer Rs, 2400 CGST paid by the consumer to retailer = i Rs. 40,000 =Rs. 2,400 Total GST paid by the consumer = Rs 2400 + Rs 2400 = Rs 4800 ¢) GST paid by the retailerto govt. Rs 4800- Rs 3840=Rs 960 ) GST paid by consumer =Rs 4,800 4l11.1] Calculation and Interpretation of Electricity Bill, Water Supply and other Supply Bills Electricity Bill - A bill for money owed for electricity used. Calculation and Interpretation The Electricity Bill is based upon the usage of appliances in the house over amonthly period All the appliances have a wattage label on them which tells what the device uses, E.g. Toaster is 1 KW, kettle is 2400 Watt, lightbulb is 100 Watt, TV 85 Watts ete. Most domestic customers are billed in kWh. Bills are made up of a fixed component - line charges, network charges, which is based upon the size of the main fuse (s) 10, 30. You pay that regardless of any power used, Then there is usage charge perKWh, (Unit) of cts/kWh, © Electricity bill explained through an Example 3 TVisused4 hours a day at 85 Watts/hour= 4x85 = * =0.34 Kw/ day 15 1000 Toasters used 15 minutes/day at 1000 Watts/hour=_2x7 > = 0.25 Kwh Kettle is used for 2hours/day at 2400 Watts = 2420*2 _ 4 gkwh / day 1S lightbulbs forShours / day at 100watts= 15%5%100 _ 5 sth /day 7000 Total daily usage = 12.89 kwh / day Monthly usage 30 days x 12.89 kwh/ day = 386.7 kwh / months Flatrate tariff at 22 cts / kwh =%85.07 Line charge Rs. 1.10 / dayx30 days =%33,00 So, total billis 1 18.07 forthe month Understanding Domestic electricity bill is calculated after taking the energy consumption unit at your premises. Nowadays, latest electronic hand held devices are being used and the bill collector need not have to feed the units, asit is laser receiver, Azand once itis put into the meter chamber collects all the data andinformation about the consumers and a copy of print out comes from the device as electricity bill, and is handed over to the consumers on the spot . And, the total data of the day for the consumers will be fed to the computer for keeping the records, The Tariff applicable varies trom state to state electricity boards, It will have many categories like domestic, commercial and industrial and place of worship and some are divided into sub groups to provide subsidies, from time to time as and when amended by the state governments. Generally, domestic billis calculated as per the slabs provided by the individual electricity boards. From 0-50, 51-100, 101- 200 and 200-300 above 301-500, likewise tariffs are made and fixed to control the consumption of power. These slabs and tariff rates are taught to the billing meters. Water Bills It is the amount one must pay to use water and sewage services each month. Normally water and sewage is provided by a municipality, but this isnot always. Water supply bills are usually based upon one’s usage , such as those who use more water are charged more. Calculation and Interpretation Of Water Supply Bill The water bill consists of a service charge, consumption charges and 50% of consumption charges as Sewage maintenance charge To understand, rates of services and consumption charge- Service Charge Consumption Charge Consumption permonth (litres) 1, 40/-permonth perconnection for Residential premises having 0-,6000 0 Build up area upto 200sq. meters 7,000-20,000 2/- 2. 2120/-permonth per connection for residential premises having 21,000-30,000 7/- Build up area above 200sq. metres above 30,000 1o/- 43Clarification Regarding Service Charge The Service charge leviable on the domestic consumersis as follows - 1. For a single water connection in a residential premise on a plot the service charges are leviable on the basis of the build up area of the ground floor of the premises, even if there may be anumber of floors in the premises. 2. For multiple connections in any residential area /premises on a plot, service charges shalllbe leviable on each connection on the basis of build up area of the unit, being fedby the respective water connection. For Example - 1. Ifon the ground floor of any premises there are more than one connection, then for each connection the service charge will be leviable on the basis of bulld up area of the premises served by each connection. 2, Ifthere is only one water connection in a premises having multiple floors, the service charge willbe leviable only on the build up area of the ground floor of premises against which connectionissanctioned, 3. For multiple water connections on the ground floor, feeding a residential premises on a plot area which has one or more than one floors, Service charge shall be liable against each water connection, as per build up area of ground floor only, @ Calculate your water bill yourself Example - If Build up area of your house is up to 200 Samtrs. and - # On one connection, if consumer consume water up to 6000 litres per month, consumption charges shallbe NIL and monthly bill be %40/- ‘ Onone connection, if consumer consume 10,000Iitres water permonth, monthly bill willbe %52/-. # Onone connection, if consumer consume 20,000 Iittes water per month, monthly bill willbe %82/-. Onone connection, if consumer consume 21,000Iitres water per month, monthly bill willbe%93/-. % Onone connection, if consumer consume 31,000 Iittes water per month, monthly bill willbe 2202/-